Jan. 31 (Bloomberg) -- Barclays Plc, Royal Bank of Scotland
Group Plc and Britain’s two other biggest banks may have to pay
as much as 5 billion pounds ($7.92 billion) to compensate small
businesses improperly sold interest-rate derivatives following a
probe by the U.K. financial regulator.

The lenders, including Lloyds Banking Group Plc and HSBC
Holdings Plc, have set aside about 740 million pounds to cover
the claims. Analysts say the total charges for the industry may
be much higher than that after the Financial Services Authority
said it found “serious failings” in reviews of product sales.

The claims against lenders may turn into another costly
scandal for U.K. banks still paying back customers wrongly sold
insurance on personal loans. Banks have reserved more than 10
billion pounds to cover claims on payment-protection insurance,
which was meant to cover payments on credit cards and mortgages
in case of illness or unemployment.

Barclays may have to pay as much as 2.5 billion pounds to
compensate customers over interest-rate derivatives, according
to Cormac Leech, a banking analyst at Liberum Capital Ltd. in
London. HSBC and RBS will need to earmark between 500 million
pounds and 1 billion pounds, and Lloyds could face 250 million
pounds to 500 million pounds in claims, he said.

Barclays said it has set aside 450 million pounds for
redress, while HSBC earmarked $240 million. RBS, which has
provisioned 50 million pounds so far, said in a statement today
it will “meaningfully” increase that amount.

Lloyds has set aside 90 million pounds, according to
Chirantan Barua, an analyst at Bernstein Research.

Hard Assessment

The impact “is hard to assess at this stage,” Barua said
in a note to clients. “We do not see any material enhancements
to the provisions that the banks have already taken.”

The FSA looked at 173 sales to non-sophisticated customers
and found that more than 90 percent didn’t comply with rules.

Products included caps, where customers paid a premium to
keep borrowing costs below a pre-defined maximum; swaps, where
customers locked in a fixed rate; and more complex combinations
like collars, which kept payments within a fixed range. When
interest rates fell, the market value of many swap and collar
products plunged, leaving customers out of pocket.

“The products that they sold were just absurdly complex,”
Martin Wheatley, an FSA managing director, said on BBC Radio 4
today. If small businesses can show “the break costs weren’t
clearly stated or understated or there was a mismatch with the
size of the loan,” there would be a case for compensation.

Banks offered derivatives to small business and individual
customers over concerns that they might not be able to service
loans if interest rates rose.

‘Right Thing’

Ian Gordon, an analyst at Investec Plc, said the total
charges for the industry may be less than 2 billion pounds and
likely closer to 1 billion pounds.

“We don’t see the amounts as overly material -- certainly
not in relation to PPI,” he said.

Lloyds said it’s “committed to doing the right thing.”

“Following the review we will provide redress as quickly
as possible to those small business customers where detriment is
identified,” the London based bank said in a statement.

The four banks sold 28,000 of the products since 2001,
according to the FSA.

A significant portion of the 173 cases reviewed by the FSA
are likely to result in compensation to the customer, the
regulator said.

“This review is firmly focused on the particular
circumstances of each sale,” Wheatley said in a statement.

B&Bs

The four banks will now do a full review of their sales of
the products to customers unlikely to understand the risks. Such
clients could be bed and breakfast businesses, not small
subsidiaries of large corporations or special-purpose vehicles
that had access to financial advice, according to the FSA.

“We will work with our customers to ensure a fair and
timely resolution of these issues,” RBS said in a statement.

The banks didn’t always disclose the costs of exiting the
products, failed to ask if the customers understood the risk,
advised hedging that didn’t match the underlying product, and
gave employees incentives to drive the sales.

The FSA said it expects the four banks to finish their
review within six months and should prioritize cases for
customers who are struggling financially. Banks with larger
reviews of the sales dating back to the end of 2001 may take as
long as 12 months, the regulator said.

Barclays will “put things right” where it hasn’t met the
“expected standards,” the bank said in an e-mailed statement.
“We look forward to engaging with eligible customers.”

HSBC said it will write to customers soon with details of
the review and tell them later whether they may be compensated.

“Where customers have suffered unfairly the banks have all
agreed that they will put it right,” said Anthony Browne, the
chief executive of the British Bankers’ Association, a lobby
group for the finance industry.